5 Simple Ways To Beat The Market: Part 4 Of 5

| About: ProShares S&P (NOBL)

Summary

Investors should understand simple, low cost, and easy-to-implement strategies that have been shown to outperform the market over long time intervals.

The fourth strategy of five I have described in a series of articles is the long-term benefits of consistent dividend growth investing as demonstrated by the Dividend Aristocrats.

Investing in companies with long track records of continuously increasing dividends to shareholders has been shown to outperform on both and absolute and risk-adjusted basis over time.

Through three articles published Monday through Wednesday, this article, and a culminating article on Friday, I am showing readers five buy-and-hold approaches that have historically "beat the market," providing absolute and risk-adjusted returns in excess of the most commonly used domestic equity benchmark - the S&P 500.

As I have described in the opening to my articles in this series, the improvement in the access to financial markets for the average investor over the trailing generation has been astounding. Thirty years ago, buying stocks often meant picking up your rotary phone and dialing your broker, paying him to enter often you into a front-loaded fund with an active manager seeking (and more often that not failing) to beat the market. Today, individual investors can access their discount brokerage via their smart phone to inexpensively purchase an index fund that replicates broad market benchmarks less miniscule tracking error and expenses.

Both then and now, the index that active managers have been trying to best is the S&P 500. Today, novice individual investors via low cost exchange traded funds like the SPDR S&P 500 ETF (NYSEARCA:SPY) can essentially tie the market that we paid Wall Street experts so handsomely to try to beat. All it will cost is a trading commission less than or equal to the cost of a sandwich, and an expense ratio of 0.095%, or $0.95 on $1,000.

The technological advances necessary for that transformation have been remarkable. One might expect that the reduction in the cost of financial intermediation would have improved the proportion of U.S. households with access to the stock market. They would be very mistaken. Less that 14% of U.S. households directly own stocks, which is less than half of the amount of households that own dogs or cats, and less than half of the proportion of households that own guns. The percentage of households that directly own stocks is even less than the percentage of households that have Netflix or Hulu.

On this portal, readers are "Seeking Alpha", or the ability to earn risk-adjusted returns in excess of the market. My articles implicitly assume that readers have decided that market returns are not sufficient for them, and have chosen to take active bets in an effort to outperform. This article describes the fourth of five buy-and-hold approaches that have outperformed the market over the trailing twenty years. These strategies are factor tilts from the broader market, and I will describe, supported by academic research, why I believe they have generated long-run alpha.

Dividend Aristocrats

While people can complicate investing in a myriad of ways, only two characteristics ultimately matter - risk and return. My personal and professional investing revolves around the simple maxim of trying to earn incremental returns for the same or less risk. The strategy highlighted below has accomplished this feat over long time horizons, and is easily replicable in financial markets.

In addition to the bellwether S&P 500, Standard and Poor's produces the S&P 500 Dividend Aristocrats Index. (Please see linked microsite for more information.) This index, which is replicated by the ProShares S&P 500 Dividend Aristocrats ETF (BATS:NOBL), measures the performance of equal weighted holdings of S&P 500 constituents that have followed a policy of increasing dividends every year for at least 25 consecutive years. To put this into perspective, the average S&P 500 constituent now stays in the index for an average of only eighteen years, so the list of companies who have had the discipline and financial wherewithal to pay increasing dividends for an even longer period is necessarily short at 56 companies (10.3% of the index). A list of the current constituents with some financial detail is appended at the end of this article.

Detailed below is a twenty-year return history for this index relative to the S&P 500. The Dividend Aristocrats have produced higher average annual returns, outperforming the S&P 500 by 2.5% per year. This approach has also produced returns with roughly three-quarters of the risk of the market, as measured by the standard deviation of annual returns as demonstrated in the cumulative return profile graph and annual return series detailed below:

Source: Bloomberg, Standard and Poor's

Notably, the Dividend Aristocrats outperformed the S&P 500 in every down year for the latter index, gleaning part of its outperformance through lower drawdowns in weak market environments. Another notable factor of the dividend strategy is that when it underperformed the S&P 500 by the largest differential (1998, 1999, and 2007) the market was headed towards large overall losses. Perhaps, this correlation is spurious and not a leading indicator, but it makes sense that prior to the tech bubble burst in the early 2000s that the Dividend Aristocrats naturally featured less recent start-ups because of the long performance requirements for inclusion. It also makes sense that when markets were heading to new all-time highs in 2007, the market correction in 2008 would be less severe for the high quality constituents in the Dividend Aristocrats index.

I have now dedicated four paragraphs to dividend growth investing in companies with a policy to offer consistent and growing dividends without addressing the elephant in the room. Do dividends matter?! Certainly academics have long contested that dividends should not matter to the value of the firm, and can even be inefficient given shareholder taxation. Absent taxes, investors should be indifferent between a share buyback and a dividend, which are different forms of the same transaction - returning cash to shareholders. Paying dividends when the firm has projects that can earn a return above their cost of capital would lower the value of the firm over time. Merton Miller, Nobel Prize winner and one of the fathers of capital structure theorem, tackled the debate in a 1982 paper entitled "Do Dividends Really Matter." My takeaway from his qualitative analysis is that paying consistently rising dividends is a discipline that ensures that the company is appropriately levered and making well planned investment decisions.

In yesterday's article on exploiting the Low Volatility Anomaly, I demonstrated that lower risk stocks have outperformed the broader market and higher risk stocks over the last twenty plus years in markets around the world. The business model of Dividend Aristocrats must be inherently stable and produce continual free cash flow through the business cycle or these companies would not be able to maintain their record of paying increasing dividends for over a quarter century. The return profile of the Dividend Aristocrats is much more correlated to the S&P Low Volatility Index (SPLV, r= 0.92) than the S&P 500 (r = 0.84 ), which lends credence to the strategy's low volatility nature and stability through differing market environments. I have chosen to detail the Dividend Aristocrats and Low Volatility stocks separately because I believe part of the strong performance of the Dividend Aristocrats is also attributable to the fifth factor tilt highlighted in my concluding article in this series to be published tomorrow.

Disclaimer:

My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: The author is long NOBL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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